What are the Causes of Inflation?

Remember that Keynesians assume that the long run aggregate supply (LRAS) curve is horizontal, upward sloping and then vertical. Assume that the current level of aggregate demand is AD1. The price level is P1 and the level of real output is Y1. There is a lot of spare capacity in the economy. The level of output is nowhere near the full employment level YFE. An increase in aggregate demand (AD from now on) to AD2 in this situation, due to a rise in government spending, for example, will cause in increase in real output (to Y2) with no penalty in terms of rising prices.

Further increases in government spending would start to be inflationary. A shift in the AD curve from AD2 to AD3 will increase real output (from Y2 to Y3) but the price level will also rise (from P1 to P2). The result is similar if AD rises to AD4. At this stage, the economy is approaching the full employment level of real output, so some industries still have some spare capacity but others will be at full capacity, resulting in price rises in some industries, and so a rise in the average price level when AD rises.

A further increase in AD when the economy is at full employment (AD level AD4) will simply result in a price rise with no increase in the level of real output.

The diagram shows that increases in the level of demand in an economy cause inflation. The rising level of demand is 'pulling' the price level up, hence the name 'demand-pull' inflation.

This effect can also be shown on the 45-degree diagram, where a level of demand above that which gives a full employment equilibrium results in an inflationary gap.

The best example of this happening in the UK economy was the consumer boom of the late 80s. Excessive demand in the economy forced the inflation rate up to 10%.

This cause of inflation is associated with rises in the costs of an industry, or the economy generally. The main reasons why costs might rise are (i) increases in wages and salaries (the biggest cost of production economy wide); (ii) increases in the cost of raw materials; (iii) increases in the price of imported goods (either as finished goods, semi-finished manufactures or raw materials) due to a fall in the value of the £ or price rises in the country of origin; (iv) increases in indirect taxes (or reductions in government subsidies). Any of these factors will have the following effect:

Short run aggregate supply (SRAS) curves have been used, but the analysis could be applied to LRAS curves. Quite simply, an increase in the costs of an economy will shift the SRAS curve to the left (from SRAS1 to SRAS2) causing the price level to rise to P2 and the level of real output to fall to Y2.

The oil price shocks of the mid 70s and early 80s are good examples of large increases in costs causing inflation. The militant trade unions made things worse by insisting on above inflation pay rises to make up for the price rises plus any unpredictable future rises in the price level.

This brings us onto an important subsequent effect of cost-push inflation, namely, wage-price spirals. During the price rises of the mid 70s, caused by the initial supply side shock of the huge rise in the price of oil, trade unions would press for higher wages. They were powerful bodies in those days and usually got what they wanted. Firms were forced to raise their prices to maintain profit levels. The loss in international competitiveness may well cause the £ to fall in value, increasing the price of imported goods. These further increases in the price level caused more demands for higher wages from the trade unions. If successful, firms would raise their prices again, and so on. The price level would spiral out of control.

The unions may well have been aware that continual increases in their wage were self defeating because the real value of these increases was quickly eroded by the subsequent rises in the price level, but which union was going to act sensibly first? Only if all unions stopped asking for more money would the spiral be broken.

The effect was made worse by the 'leap-frogging' that took place. If the car workers got 15%, the miners wanted 17% and the steel workers wanted 20%. The car workers would then go back to their employers and say, "the steel workers got 20%, so we want at least 20%."

The last two causes of inflation were Keynesian explanations. As was said earlier, monetarists believed that sustained inflation would only occur if there was an increase in the money supply. The 'Quantity Theory of Money' can be used to explain the monetarists' point of view.

The money supply (M) is the amount of money in the economy. There are lots of definitions as to what exactly constitutes money, but for the time being, let us assume that it includes only notes and coins.

The velocity of circulation (V) refers to how quickly this money 'circulates' around the economy. One ten pound note may get spent three times in one week. So M times V is, effectively, equal to the 'money spent' in an economy.

P is the price level and y is the level of real output, or real income (some textbooks will use 'T' for transactions), which ever you prefer. P times y, therefore, represents the value of everything on which money is spent.

It has to be true that MV = Py. Money spent = what the money is spent on. That is why there are three horizontal lines instead of the usual two (the equals sign). This means that, rather than being an equation, this is an identity. Whatever is on the left (MV) always equals whatever is on the right (Py).

So far, this identity does not help us much. If, as the monetarists have done, one makes assumptions about certain variables in the identity, then things start to get interesting. Monetarists believe that V is fairly constant in the long run.

They also claim that, whilst y is not constant, it does tend to grow at a predictable rate. The 'trend' growth rate in the UK is currently 2.5%. More particularly, monetarists believe that the long term 'trend' growth rate is determined by the position of the vertical long run aggregate supply curve which, in turn, is determined by supply side polices. They believe that y is exogenous, or determined outside this particular model.

Now the identity becomes a meaningful equation. If V is constant and y is at least predictable, then any significant change in M will cause a similar change in P. So large rises in the money supply (M) cause large rises in the price level (P).

A fairly simple theory really. Of course, the Keynesians highlight many pitfalls. What if V is not constant? Good question. Many economists think this may be why the Thatcher experiment of the early 80s did not work. She was very keen on this theory. She tried to control the money supply through high interest rates and attempted control of government borrowing. Not only did she have problems in controlling the money supply, but the theory just didn't seem to work. When the money supply grew faster than she had planned, inflation still fell and when the money supply was finally under control, inflation started to rise again!

When the percentage changes in M and P are relatively small (as they are in the UK), then any significant change in V will totally muck up this simple looking theory. This theory works very well in countries that keep printing money in a desperate attempt to save the economy (like Russia). If M is growing at, say, 100%, then changes in V and y will be so small in comparison that P is bound to rise substantially.

Other problems involved the time lags between changes in the money supply and price changes and, probably the most important point, does M affect P, or is it P that affects M?

Monetarists argued that the increase in M meant that consumers and businesses found that they had excess money balances, which would be spent (consumers) or invested (firms). This caused an increase in aggregate demand and inflation.

Keynesians argued that the rise in inflation was caused by factors in the real economy (demand-pull and cost-push). The money supply would then expand to accommodate the increase in aggregate demand. In other words, Keynesians believed the causal link was the other way round - increases in price (caused by the real economy) caused increases in the money supply and not that increases in the money supply caused increases in the price level.